Aviation Economics & Finance
Professor David Gillen (University of British Columbia )&Professor Tuba Toru-Delibasi (Bahcesehir University)
Module 11 : 26 November 2015Istanbul Technical UniversityAir Transportation Management M.Sc. Program
OUTLINE
• Introduction
• Mergers and Acquisitions (M&A)
• Process and Issues
• Economics of M&A
• Introduction to competition policy and regulation
– rationale for competition policy
– origins and historical development
– regimes: EU, UK, USA and TR
– utility privatisation and regulation
• Examples3
November 23-28
A. INTRODUCTION
November 23-28 4
• The airline industry is cyclical and its performance is closely linked to
the gross domestic product (GDP).
Figure 1: GDP Growth and TK Air Traffic Growth
TURKISH AIRLINE STRATEGY
5November 23-28
US AND WORLD’S GDP 2004-2012
6November 23-28
Figure 2: Turkish Airlines Total Passengers and Net Income
TURKISH AIRLINES STRATEGY
7November 23-28
• Competitive Cost Structure
Figure 3: Network Development of Turkish Airlines
TURKISH AIRLINES STRATEGY
8November 23-28
• Geographic Location
Figure 4: Global Economic Center of Gravity (from 1971 to 2031)
Source: Turkish Airlines from Airbus Global Market Forecast (2012-2031)
TURKISH AIRLINES STRATEGY
9November 23-28
• Competitive Cost Structure of Turkish Airlines
Figure 5: The unit costs of selected airlines (2013 Airlines’ Annual Reports)
TURKISH AIRLINES STRATEGY
10November 23-28
AIRLINE COOPERATION AND CONSOLIDATION
• Aviation is a fast changing world – Ethiad has teamed with Air France/KLM.
– Qatar Airways is now firmly part of Oneworld
– Rumors: Emirates and Lufthansa are talking
• Turkish has chosen to not use mergers as a strategy,
and only uses weak alliances– TK could change strategy
– Future success is highly dependent on negotiationg new bilateral
rights to further expand its hub network
11November 23-28
MANY FORMS OF COOPERATION POSSIBLE
• Code-sharing agreements between two
airlines
• Membership in global airline alliances
• Joint ventures to share both revenues and
costs
• Mergers and acquisitions
12November 23-28
B. MERGERS AND ACQUISITIONS
November 23-28 13
MERGERS AND ACQUISITIONS• Merger:
– is where two companies come together to combine and share
resources to achieve a common objectives
• Under merger the combining firms remain
– Joint owners
– New company is created
Company
A
Company
B
Company
C
14November 23-28
MERGERS AND ACQUISITIONS
• Takeover or Acquisition:
– one firm purchase the assets of another, with the acquired firm ceasing
to be the owners of the firm. Often it is the larger company which
acquires a smaller one.
Company
X
Company
Y
Company
X
15November 23-28
TYPES OF M&A• Horizontal
– Two companies engaged in similar activities are combined.
• Vertical
– Firms from different point in the same production process to combine
• Conglomerate
– Occurs when two businesses in unrelated industries decide to combine
16November 23-28
GAINS FROM M&A• Increase market power
– To have access to another network
– Value creation by exploiting collusive synergies
• Operational gains– Reducing operational cost by synergy effects
• Economies of Scale– To enable benefits of scale to be achieved
– Better contracts with suppliers
17November 23-28
FACTORS AFFECTING M&A ACTIVITY OF
AIRLINES• Airline industry is a challenging industry with low profit margins and
high volatility of returns
Figure 6: EBIT margin and Net post-tax profit margin
Source: ICAO and IATA
18November 23-28
FACTORS AFFECTING M&A ACTIVITY OF
AIRLINES• What was happening on TK side?
Table 2: TK Airlines summary profit and loss account (USD million): 2009-2013,
1H2013-1H2014
Source: Turkish Airlines
Income Statement
(million USD)
2009 2010 2011 2012 2013 1Q2013 1Q2014 13/12
Change
Operating Revenue 4552 5488 7070 8234 9826 2015 2315 19%
Operating Expenses
(-)
4058 5149 6855 7616 9249 2062 2418 21%
Operating Profit 494 299 215 618 577 -48 -102 -6.6%
Net Profit 362 185 11 657 357 -14 -102 -45.6%
Net profit
% of Revenue 7.9% 3.4% 0.15% 7.9% 3.6%
19November 23-28
FACTORS AFFECTING M&A ACTIVITY OF
AIRLINES• Operating costs keep surging
– The industry is facing higher operating costs, in particular due to
increases in fuel costs which currently account for 25-40% of airline
operating osts
Figure 7: Main Cost Divers (2012 Operational Cost Structure)
Source: IATA
20November 23-28
FACTORS AFFECTING M&A ACTIVITY OF
AIRLINES• Saving fuel costs
Figure 8: Fuel efficiency and the price of jet fuel
21November 23-28
FACTORS AFFECTING M&A ACTIVITY OF
AIRLINES
• Bankruptcies
– Cost advantage due to economics of scale and scope
– Higher demand due to better connectivity, greater range of destinations
and increased service frequenct
• High incidence of bankruptcies in the airline
industry following deregulation
– Continuing trend among major carriers to restructure under bankruptcy
protection in the US
22November 23-28
• Mergers and acquisitions (M&A) are complex, involving
many parties.
• Mergers and acquisitions involve many issues, including
– Corporate governance.
– Form of payment.
– Legal issues.
– Contractual issues.
– Regulatory approval.
• M&A analysis requires the application of valuation tools
to evaluate the M&A decision.
MERGERS AND ACQUISITIONS (M&A)
23November 23-28
Country Limits on foreign ownership
Australia-New Zealand 49% for airlines engaged in international operations, 100% for
solely domestic
Canada, Mexico 25%
China 35%
Chile 100% as long as airline’s principle place of business is in Chile
EU 49%, applies to non-EU citizens
India 49%, but foreign airlines cannot hold shares in Indian airlines
Japan, Taiwan 33.33%
Korea 49%
Malaysia 45%
Singapore 27.51%
Thailand 30%
United States 25%, one-third of the board of directors, chairman/woman,
CEO/president must be US national
Turkey Majority of the shares must be hold by Turkish national24
November 23-28
WHAT IS ALLIANCES
• An alliance is an agreement (both vertical and horizontal) between
two or more airlines that enter into a form of cooperation and may be
passenger and/or cargo
– Global alliances (Star, SkyTeam and Oneworld)
– Bilateral and multilateral alliances (marketing alliances, joint ventures, code
share, etc.)
• Alliances are subject to regulatory approval depending on its
integration level
– US regulators may grant anti-trust immunity to international alliances
– EU regulators may grant anti-trust immunity to international alliances
– Both the US and EU will consider whether or not there is a signed Open Skies
Agreement with the foreign carrier’s government
25November 23-28
AIRLINE COOPERATION
26November 23-28
METAL-NEUTRAL JOINT VENTURES
27
• Metal-neutral joint ventures
– High degree of integration
– The most intensive form of an airline alliance
– Revenue & profit sharing
– Joint setting of prices and schedules
– Similar to a merger but no ownership transfer
• Metal-neutral joint ventures in major aviation markets
– Transatlantic
• Star A++ (Lufthansa Group, Air Canada, United/Continental)
• SkyTeam Joint Venture (Air France / KLM, Delta and Alitalia)
• Oneworld Joint Venture (American, British Airways / Iberia)
– Transpacific
• Star Joint Venture (United / Continental, ANA)
• Delta/Virgin Australia Joint Venture
• American / JAL Joint Venture
November 23-28
WHY ALLIANCES?• Foreign ownership rules
– Many countries prohibit or limit ownership of domestic airlines.
International or cross-border mergers are rare. Instead, the benefits of a
merger can be achieved through an alliance.
• Restrictions on cabotage rights
– Countries generally restrict foreign airlines from operating domestic
service. There are exceptions (e.g. the European Union, Australia
allowing some cabotage as extension of long haul routes).
• Access to a larger global network
– Airlines can increase service frequency and number of destinations
served by participating in an alliance. Increased connectivity may
improve load factors.
28November 23-28
WHY ALLIANCES?• Marketing cooperation
– Frequent Flyer Programs
– Codeshare Agreements
– Lounge Access
– etc.
• Cost synergies
– Shared airport facilities
– Joint scheduling
– Reciprocal sales arrangements
– Increased buyer power
• Decrease in competition
– Airline alliances have a potential to diminish or exclude competition.
– Pro- and anti-competitive effects will be discussed in Module 10.
29November 23-28
TRENDS IN AIRLINE ALLIANCES
• Many major airlines have joined a major alliance grouping (Star,
SkyTeam or Oneworld)
– Over 50 carriers are members of one of the three major alliances
– These carriers represent two-thirds of industry’s ASKs
– LCCs begin to join global alliances. In 2012, Airberlin joined oneworld
• There is a tendency towards seeking deeper cooperation by airlines
via bilateral and multilateral alliances
– “metal neutral” joint ventures are a form of a super-alliance which is very
similar to a merger.
• Several major carrier that have deliberately avoided alliances seek
increased cooperation on a bilateral basis (e.g. Emirates, Etihad)
30November 23-28
C. PROCESS AND ISSUES
November 23-28 31
ETIHAD’S STRATEGIC PARTNERSHIPS
32November 23-28
AIR TRAFFIC PARADIGM SHIFTS
33November 23-28
QANTAS AND EMIRATES PARTNERSHIP
34
• Before
– Qantas had 5 one-stop destinations in Europe (via QF operations or
codeshares)
– No service to Middle East/North Africa
• After
– 32 once-stop destinations in Europe and 31 one-stop destinations in
Middle East/North Africa via DXB
– Revised service to SIN/HKG/KUL for better connectivity to Asia
November 23-28
RECENT M&A AND JOINT VENTURES IN THE US
35November 23-28
NORTH ATLANTIC ALLIANCE AND NON-ALIGNED
MARKET SHARES
36November 23-28
NORTH ATLANTIC ALLIANCE STRUCTURE
37November 23-28
WHAT MAKES AN ALLIANCE SUCCESSFUL?
• Factors that affect success of an alliance:
– Aligned expectations
– Win-win financial provisions
– Cultural compatibility (corporate and national)
– Consistent quality and other customer relations
– Network fit
– Well-coordinated IT systems
• E.g. WestJet-Southwest failure
– Smooth airport interfaces
– Coordinated selling and distribution
38November 23-28
DISCUSSION: LUFTHANSA AND TURKISH AIRLINES
RELATION
• In 2006, LF sponsored TK’s application to join Star
Alliance
• Since 2010, TK and LF had been seeking closer co-
operation
• In 2013, LF decided to end its codeshare agreement with
TK
• Reasons:
– Strong growth of TK in Germany in particular secondary German cities
(TK has more than three times LF’s weekly frequencies between
Germany and Turkey)
– LF cannot match the fares with TK
39November 23-28
D. ECONOMICS OF M&A
November 23-28 40
ECONOMICS OF M&A• Key airline industry trends:
– Increased penetration of mergers and alliances
– Industry consolidation
– “Hub and spoke” route systems post-deregulation
• On the one hand, increased industry consolidation and
hub-and-spoke systems allow airlines to benefit from cost
economies and passengers from better connections, higher
frequency of service and a wider range of destinations.
• On the other hand, these trends can lead to enhanced
ability by carriers to exercise market power, exclude
competition and cause consumer harm.
November 23-28
41
COMPETITIVE LANDSCAPE• Characteristics of the airline industry that favour anti-
competitive practices
– Hub concentration
– Airports slot constraints
– Price Transparency
– Multi-market contact
November 23-28
42
COMPETITIVE LANSCAPE• Competition from other modes of transport is limited or
ineffective
– High speed trains may be a substitute on some route
– Other ground transport is generally not an effective substitute
– For most routes, airlines have no substitutes
• Business travellers account for a disproportionate share of
airline profits
– The 20/80 rule
– Time-sensitive travellers are typically the focus of antitrust concerns
November 23-28
43
RATIONALE FOR COMPETITION POLICY• Economic efficiency
– allocative
– productive
– “perfect competition” condition of first fundamental theorem of welfare
economics
• Wider economic benefits
– competitiveness and growth
– reform of UK competition policy in late 1990s/early 2000s based on idea that
competition is good for productivity and growth
• Political interests
– protection of consumers
– competition as a substitute for state intervention?
November 23-28
44
E. INTRODUCTION TO COMPETITION
POLICY AND REGULATION
November 23-28 45
COMPETITION POLICY REGIMES
• European Union
– agreements between firms: Article 101 (formerly 81) TFEU
– single-firm conduct: Article 102 (formerly 82) TFEU
– merger control: EC Merger Regulation (1989, amended 2004)
• United Kingdom
– agreements between firms: Chapter I of Competition Act 1998;
Enterprise Act 2002 (stronger measures against cartels)
– single-firm conduct: Chapter II of Competition Act 1998
– merger control: Enterprise Act 2002
• United States
– monopolisation (agreements & single-firm conduct): Sherman Act 1890
– merger control: Clayton Act 1914
• Turkey
– Article 4054 (Turkish Competition Authority)
November 23-28
46
US ANTITRUST LAWS• Sherman Act 1890
– Section 1: prohibits contracts, combinations & conspiracies in restraint
of trade
– Section 2: prohibits monopolisation, attempts to monopolise &
conspiracies to monopolise trade
• Clayton Act 1914
– prohibits price discrimination & some vertical restraints, where these
“substantially lessen competition” (SLC)
– merger control: SLC test
• Federal Trade Commission (FTC) Act 1914: set up
FTC
November 23-28
47
EU & UK: AGREEMENTS BETWEEN FIRMS
• Art. 101 / Chapter I of Competition Act 1998 prohibits
“ … all agreements between undertakings … which have as their object
or effect the prevention, restriction or distortion of competition”
• Includes
– price fixing
– limiting production or investment
– market sharing
– applying dissimilar conditions or supplementary obligations
• Exemptions: agreements that are necessary to
– improve production or distribution
– promote technical progress
November 23-28
48
EU & UK: ABUSE OF DOMINANCE
• Art. 102 / Chapter II of Competition Act 1998 prohibits
“Any abuse ... of a dominant position”
• Abuse includes
– imposing unfair prices or conditions
– limiting production or technical development
– applying dissimilar conditions or supplementary obligations
• What is “dominance”? Is it the same as monopoly?
– “position of economic strength … which enables it to prevent effective competition”
(United Brands, 1978)
– “does not preclude some competition” (Hoffman-La Roche)
• What is the “relevant market” within which the firm operates?
– econometric evidence on substitution between products
November 23-28
49
INTERNATIONAL COOPERATION
• Since 1991 the European Union and the United States have been
coordinating regulatory reviews
– transatlantic alliances
– mergers and acquisitions affecting the transatlantic market
– joint studies on the impact of alliances
• Different approaches in different jurisdictions may lead to
inconsistent decisions or remedies
– E.g. Transborder Joint Venture between Air Canada and United/Continental
• The US Department of Transport granted antitrust immunity (with
carveouts on 6 routes in total)
• Canada’s Competition Bureau challenged the JV in court with a
subsequent settlement (additional carve-outs on 10 routes in total)
November 23-28
50
ANTITRUST ANALYSIS OF M&A
• Competition authorities are likely to start with the
view that a merger that may lessen competition is
undesirable, especially if:
– The merged airline has dominant position
– There is no effective competition
• Thus, the merging airlines must show that the
benefits of the merger will offset the costs
November 23-28
51
BENEFITS OF THE MERGER
• Cost efficiencies for airlines
– Benefits to airlines from reducing costs matter
• Increased revenues/prices for airlines
– Benefit to airlines from higher fares that result from reduced
competition is not a benefit from an antitrust law point of view
• Benefits for passengers
– Better service (connectivity, scheduling, FFp integration, lounge
access, etc.)
– Better price that may result from cost savings
November 23-28
52
BENEFITS VS COST OF AN AIRLINE MERGER
• Competition authorities will compare potential
benefits to the costs of an airline merger
– Fare
• Complementary vs parallel (overlapping) networks
• City-pair vs inter hub passengers
– Reduced capacity
• A cost if fewer passengers are served
• A cost if less choices for passengers
• A benefit if capacity reduction leads to costs savings
November 23-28
53
COMPLEMENTARY VS PARALLEL NETWORKS
• The anti-competitive effect of a merger/alliance between
two airlines is
– smaller if the networks have limited or no overlap
– greater if the networks have substantial overlap
November 23-28
54
NETWORK RATIONALIZATION
• The impact of mergers and alliances
– Rationalization of networks and removal of competing hubs
• Increased traffic density and reduced flight frequency
– Potential reduction in competition in markets previously served by the
merger partners
November 23-28
55
ANTITRUST ANALYSIS
• The presence of remaining competition in the market
– A major focus
• Based on the idea that effective outstanding competition
disciplines exercise of market power
– Prevents the cost of higher fares
– Prevents the cost of reduced passenger choices
– Allows for the benefit of the merger
• Competition from carriers operating indirect
service will be considered
– Generally not a good substitute for non-stop service
November 23-28
56
MERGER GUIDELINES
• Clarify when government agencies are likely to act
to impede merger
• Articulate a 5-step procedure
1. Market Definition
2. Is there a substantial share of the market?
3. Is the exercise of market power probable?
4. What are the efficiencies?
5. Are the costs of exercising market power greater than the generated
efficiencies?
November 23-28
57
1. MARKET DEFINITION
• Product market
– Business travellers/Leisure travellers
– Economy/Business/First Class
– Connecting/Non-stop passengers
• Different time and price sensitivity
• Different preferences for low cost and full service
airlines
– Virgin estimated that time sensitive passenger on london-NY value
time at $240 per hour
November 23-28
58
1. MARKET DEFINITION
• Airline Relevant Geographic Market
– Airport pairs
– City pairs
• Airline markets are usually defined as city pairs
– Entire networks
– Hub airport
November 23-28
59
2. BASIC MARKET CONCENTRATION INDEX
• The Herfindahl-Hirschman Index (HHI)
𝑯𝑯𝑰 =
𝒊
𝑵
𝒔𝒊𝟐
where 𝒔𝒊 is the market share of firm 𝒊, and 𝑵 is the number of the firms in the
market. The HHI ranges between 0 to 10000. (multiplied by 𝟏𝟎𝟎𝟐)
HHI Concentration Level and Possible Government Action
Post-Merger HHI Concentration Change in HHI Government Action
Less than 1,000 Not concentrated Any amount No action
Between 1,000 and 2000 Moderately concentrated 250 or more Possible challenge
More than 1,800 Highly concentrated 150 or more Challenge
November 23-28
60
EXAMPLE 1: HHI• Consider an O-D where six carriers are operating. Their
respective market shares are as follows
• What is the likely government action, if any, if companies
E and F merged?
Company Market Share
A 25%
B 15%
C 15%
D 15%
E 15%
F 15%
November 23-28
61
EXAMPLE 1: HHI
• The O-D market would be considered moderately concentrated
before and after the combination of E and F.
• The change in the HHI is 450, which may result in a gov’t challenge
Company
Market
Share
HHI
Before Company
Market
Share
HHI
After
A 25% 625 A 25% 625
B 15% 225 B 15% 225
C 15% 225 C 15% 225
D 15% 225 D 15% 225
E 15% 225 E+F 30% 900
F 15% 225
Total 100% 1125 Total 100% 1575
November 23-28
62
EXAMPLE 2: HHI
• From Tuscon to New York
𝑯𝑯𝑰 =𝟐
𝟑
𝟐
+𝟏
𝟑
𝟐
∗ 𝟏𝟎𝟎𝟎𝟎 = 𝟓𝟓𝟓𝟓. 𝟔
Likely to challenge because highly concentrated
operated only by two unequal size firms.
Airlines Route Tickets Sold Market Share
AA TUS-Newark 400 0.67
UA TUS-Newark 200 0.33
November 23-28
63
3. ASSESSING MARKET POWER
• Market power is defined as:
– I the ability to protably sustain prices above competitive levels
OR
– the ability to restrict output or quality below competitive levels.
• A firm with the market power may harm the competition by
– weakening existing competition
– raising entry barriers
– slowing innovation
• Market power can be possessed by a single firm or group of
firms
November 23-28
64
MARKET SHARE
• High market share may be an indication of market power
– Determined in reference to the relevant market
– Measured in traffic, revenue, frequency, etc.
– Safe harbours
• A market share below 35% will not raise concerns
• A market share above 60% will likely raise concerns
November 23-28
65
HIGH MARKET SHARE BUT NO MARKET POWER
• But high market share does not automatically
equal market power– Barriers to entry need to be analyzed
– Contestable market theory
November 23-28
66
ENTRY BARRIERS• Airport slot constraints
– Large airports operate nearly at capaciy
• E.g. Heathrow is currently at 99% capacity
• Other major airports in NY, London, Tokyo etc. are also slot constrained
– Dominant airlines hold slots and limit new entry
• Access to airport facilities
– Terminals, gates, check counters, etc.
• Computer Reservation Systems
– Display Bias
– Booking Fees
– Travel agent incentives
November 23-28
67
ENTRY BARRIERS• State ownership
– Limits sources of finance for new entrants
– Government “bailouts” or subsidies limit or impede new entry
• Loyalty programs
– Act as a volume discount
– Principle-agent problem (business travellers)
– The effect is greater for loyalty programs where points can be accumulated
faster or where an airline has a broader network
– Incumbent airlines may be required to grant competitor access to their frequent
flyer programs
• Discounts to large corporate customers
– On the condition that all or nearly all travel is booked with a specific airline
November 23-28
68
REMEDIES
• If a merger is undesirable from an antitrust point of view, measures
can be adopted to reduce its harmful impact
– Reduce entry barriers to other competing airlines
• slot divestiture at congested airports
– Carve out selected routes from a joint venture
• applied primarily where the merging airlines are the only operators
• approach used by the United States in granting antitrust immunity to
international alliances
– the carriers can get approval without the carve outs but they
must present evidence that benefits will offset costs
– Agreement that the merged carriers will not undercut prices postmerger
• or engage in other forms of anticompetitive conduct
November 23-28
69
REMEDIES
• Structural remedies
– Airport slot divestiture
– Market share restrictions on key routes
• used by the European Commission
• Behavioral remedies
– Mandated access to essential facilities or services
• computer reservation systems, terminal gates, loyalty programs, etc.
– Obligation to interline
• or enter into other arrangements that facilitate competition
– Carve outs
• prohibition to coordinate on certain routes (carve outs)
• used by the United States / Canada
November 23-28
70
E. EXAMPLES
November 23-28 71
SELECTED M&A CASES 2005-PRESENT
• Delta and Northwest Merger
– On April 14, 2008 DL and NW announced a $17.6 billion merger, DL
was the second and NW was the forth largest US carrier
– Both operated under hub-and-spoke system
– September 26, 2008, two airlines’ shareholders approved the merger
– October 29, 2008 DoJ approved their merger
• Claiming the potential for substantial cost efficiencies with little or no harmful
effects in competition.
– As of 2009, NW’s aircrafts have operated under Delta and NW’s hubs
have been fully consolidated with Delta’s brand
72November 23-28
SELECTED M&A CASES 2005-PRESENT
• Lufthansa and Swiss Air (2005)
– LX is acquired by LH
– LH made a move on several smaller European carriers, Swiss Air,
Austrian Airlines and BMI (which they sold to British Airways in
2011) in separate deals
– LH also purchased 19% of U.S. carrier Jetblue in 2007
73November 23-28
SELECTED M&A CASES 2005-PRESENT
• AMR and US Airways Merger
• U.S. Airways proposes merger to bankrupt AMR.
April 2012
• AMR creditors encourage AMR to merge with another airline, instead of emerging from bankruptcy alone.
July 2012
• AMR and U.S. Airways begin merger discussions.
September 2012
• U.S. Airways proposes merger, with its shareholders owning 30% of the new company.
November 2012
• Details of the merger are worked out.
• Merger filed with the FTC under Hart-Scott-RodinoAct.
February 2013
74November 23-28
END OF MODULE 11
November 23-28 75
